What makes a business worth owning? It is said that, ultimately, investors want stable income. Nowadays, there’s so much online information about investing. Anyone can easily set up an investment account with an online brokerage and become a self-directed investor to start earning dividend income from dividend stocks.
If you’re really keen on learning, you can always pick up some investing books from Amazon or borrow from the library to reduce clutter at home. Additionally, you can study some related programs at a college or university.
What makes a dividend stock worth investing in? Maybe investors want a dividend stock that pays a high enough yield. Also, they’d prefer safe and ideally growing dividends that are supported by quality businesses.
Does a dividend stock pay a sufficiently high yield?
As interest rates are rising, lower-risk fixed-income investments like bonds and GICs will compete against stocks for investors’ capital. As a result, it makes good sense to require a bigger yield on new capital you’re putting into the market. Since stock prices have come down from a market correction, yields have also increased.
Lowell Miller stated in The Single Best Investment that a sufficiently high yield is one that’s 1.5-2 times that of the market. The Canadian stock market, using iShares S&P/TSX 60 Index ETF as a proxy, yields about 3%. So, a sufficiently high yield today would be 4.5% – 6%.
Of course, the above is just a guideline. Some investors might still buy stocks that have a lower yield than 4.5% if the underlying businesses have below-average risk or above-average growth.
The payout ratio is one of the first metrics to look at for dividend safety. Specifically, the payout ratio is usually defined as:
payout ratio = dividends / net income
for a period.
For example, Royal Bank of Canada’s (TSX:RY)(NYSE:RY) trailing-12-month (“TTM”) net income is $16,522 million. Its dividends paid in the TTM is $6,574 million. So, its TTM payout ratio is 39.8%.
If the “net income available to common shareholders” metric is lower, you can also use it as a more stringent figure in the equation. RBC’s TTM net income available to common shareholders is $16,277 million, which results in a payout ratio of 40.4% — still very sustainable.
Investors can compare Royal Bank’s payout ratio to its past payout ratios or to the industry’s average payout ratio to further analyze the safety of its payout ratio.
Most of the time, big Canadian bank stocks maintain a payout ratio of below 50%. However, their payout ratios would be higher than normal during recessions. Investors need to be confident that the payout ratios would descend to normal levels as the economy recovered.
Even when dividend stocks have an extended payout ratio, they can still pay out healthy dividends if the companies have retained earnings (vs. accumulated deficit) on the balance sheet.
Investopedia explains that
Retained earnings are a firm’s cumulative net earnings or profit after accounting for dividends. They’re also referred to as the earnings surplus.
In the last reported quarter, RBC reported retained earnings of $75,931 million on its balance sheet. Based on its last quarterly dividend payment of $1,756 million, the stock’s annualized dividend payment is $7,024 million. So, theoretically, RY stock can cover 10.8 years of dividends if it sustained its current dividend.
Of course, not all retained earnings are meant for paying out as dividends. But it is a nice buffer that management can draw on at times of trouble. Having a large reserve of retained earnings also shows that the business has been profitable in the long run.
Notably, companies that have accumulated deficit on their balance sheets may mean they’re still in an early growth stage. It doesn’t necessarily mean they’re bad investments but that they’re higher-risk investments.
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Disclosure: As of writing, we own AMZN.
Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.
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